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Lower of Cost or Market Rule
Definition, Meaning Explained, Rationale, Example Usage

 

Owners may sometimes use theLower of cost or market rule to adjust the Balance sheet value of certain inventories and securities assets, when their market values change.

The LCM rule enables objective, verifiable reporting. The rule also helps implement the matching concept and the conservatism principle.

What is the Lower Of Cost Or Market LCM Rule?

Lower of cost or market (LCM) is an accounting rule for valuing inventory and, under certain conditions, securities holdings. Under the lower of cost or market rule, the inventory or securities value that owners report at the end of an accounting period is the lower of either (a) historical cost or (b) value in the market.

Sections below show how the rule works for inventory and for some securities holdings. Examples also show the necessary accounting transactions when values change under the LCM rule.

Explaining the Lower of Cost or Market Rule in Context.

Sections below further define, explain, and illustrate the lower of cost or market rule. Note especially that the term appears in context with related terms and concepts, from the fields of accounting, finance, and market analysis. LCM contextual terms appearing here include:

Lower of Cost or Market
Verifiable Reporting
GAAP
Book Value
Historical Cost
Replacement Cost
Market Value
Market Ceiling
Realizable Value
Market Floor
Inventory Revaluation
Securities Revaluation
Passive Investment
Active Investment
Minority Investment
Majority Investment
Marketable Securities
Investment Securities
Trading Securities
Securitles Available for Sale
Derivative Instrument

 

Contents

Related Topics


 

What is the LCM Rule Purpose?

The lower of cost or market rule serves several purposes consistent with international accounting standards. These appear almost universally in Generally Accepted Accounting Principles (GAAP) for most countries.

1. Realistic, Verifiable, and Objective Reporting.

Inventories and some securities holdings contribute to Balance sheet values for current assets. Current assets figures, in turn, play a central role in several important metrics for evaluating company performance and financial position. Asset values therefore impact metrics such as working capital, current ratio, and return on assets.

A basic principle in GAAP is that owners should report asset values that are realistic. Asset values, therefore, should reflect actual cost, replacement cost,  or current market value. Owners who report unrealistic values instead risk presenting a misleading picture of company financial performance and financial position.

 2. The Matching Concept.

The matching concept is an accounting principle, whereby owners recognize revenues in the same accounting period they report the expenses that brought them. The lower of cost or market rule can help apply the matching principle in several ways. Using the LCM rule, for instance, owners can be sure they report expenses for, say, loss of inventory value, in the same period they report revenues from sales of that inventory.

3. The Conservatism Principle.

GAAP in most countries incorporates the conservatism principle. This principle applies when there are alternate acceptable methods for reporting value of an item. The principle directs owners to choose the method that results in lower net income and/or lower asset value.

The universal use of an objective LCM rule for choosing between alternative valuing methods means the following. Those who read financial reports can expect to see always the more conservative values for inventories and securities. 

Business Strategy
Strategic Objective
Business Model
Business Plan
High Level Strategy
Generic Strategy
Competitive Strategy
Mission Statement
Vision Statement
Value Proposition
Operational Strategy
Financial Strategy
Marketing Strategy
Product Strategy
Pricing Strategy
Advertising Strategy
Growth Strategy
Outsourcing Strategy
Operational Strategy
Financial Strategy
Growth Strategy

How Do You Apply the LCM Rule?

How You Revalue Depends on the Asset Class

Almost all assets enter the accounting system with a value equal to acquisition cost. GAAP prescribes many different methods for re-valuing assets In subsequent reporting periods. Which method is preferred—or required—for any given asset? The answer can vary substantially, depending on several factors including the following.

  • Asset class.
    inventory, assets, wasting assets, intangible assets,  and property, plant and equipment assets, for instance, require different valuing methods.
  • Asset purpose or usage.
    Valuation method may depend on whether owners hold securities for long term objectives or for short term profits.
  • Acquisition method.
    Securities bought on the open market may be valued differently from securities purchased through privately negotiated deals.
  • Year of acquisition.
    Valuation method may depend on whether acquisition came before or after certain regulations and tax laws.
  • Reporting choices from company policy and practice.
    When valuing inventory, for instance, companies are usually free to choose between LIFO and FIFO methods.
  • The country's Generally Accepted Accounting Principles.
    GAAP rules for valuing assets, income, and tax liabilities, can differ from country to country. Rules for valuing and taxing capital gains, for instance, differ greatly among countries.

Examples in this article illustrate a few accounting principles in view with the LCM rule. Note especially, however, the article does not cover all situations. Keeping this in mind, we can now introduce several costing and valuing terms that are involved in applying the LCM rule.

Book Value  (or Reported Value) of an Asset

Book value is the asset's Balance sheet value after making all adjustment's. These include adjustments for depreciation, amortization, "mark to market" accounting, and the Lower of cost or market rule.

Cost, Acquisition Cost, and Historical Cost

These three terms are more or less interchangeable when referring to initial asset value. Here, cost is what owners actually pay for acquiring the asset. This includes purchase price, of course, but also any other acquisition costs such as brokerage fees or shipping costs. This cost never changes during asset life. This means there are no adjustments due to inflation, no matter how long asset ownership life. Initial cost in this sense appears in the "cost vs. market" choice under the LCM rule.

Replacement Cost

This is the cost of replacing an asset. Note especially that this cost to be either less or more than the asset's current selling price in the market. Consider for instance a merchant, selling goods in the retail market, while obtaining goods inventory from a wholesaler. In such cases, replacement cost is probably less than market price. On the other hand, if a company must purchase inventory at market prices, that plus additional acquisition costs put replacement cost above the market price.

Market Selling Price

Market selling price is the price buyers currently pay in the market for inventory or securities. Those familiar with securities markets know that securities prices over time can fluctuate above or below historical. And, the same is true for the price of most kinds of inventory. When the inventory consists of commodities such as oil, for instance, price will probably fluctuate widely over time, above and below purchase price.

Net realizable value (NRV):

The current market selling price of the asset, minus any costs for selling, disposing, or otherwise getting rid of the asset.

Market Value

When applying the LCM rule, this is the "market value" figure to compare with "cost" when applying the LCM rule. For purposes of applying the rule, market value will be taken as replacement cost (defined above), except that  the market value must fall between two limits: 

Upper Limit for Market: Market Ceiling

Net  realizable value (NRV) is the upper limit for the market value. If, say, replacement cost is higher than net realizable value, then LCM market value will be taken instead as the NRV.

Lower Limit for Market: Market Floor

The lower limit for market value is the net realizable value minus normal profit. When replacement cost is less than NRV minus normal profit, LCM market value is taken instead as the market floor, that is NRV minus normal profit. 

Rules for Setting Market Value

In the LCM market vs. cost comparison, the cost figure remains constant, no matter how long the ownership life of the inventory or securities. Market value, of course, can change with each reporting period. Keeping in mind the definitions above, the LCM rule operates as follows. The "market" value for the comparison can in fact turn out to be any one of three values

  • Firstly, Market floor.
    When replacement cost is lower than market floor, market value from the LCM rule is the market floor.
  • Secondly, Replacement cost.
    When replacement cost falls between market floor and market ceiling, market value from the LCM rule is Replacement cost.
  • Thirdly, Market ceiling.
    When replacement cost is greater than market ceiling, market value from the LCM rule is Market Ceiling.

Table 1 below shows these rules in algebraic form. And, Table 2 below illustrates the LCM rule with a numerical example.

Condition Market Value =
Replacement cost < Market floor < Market ceiling Market = Market floor
Market floor < Replacement cost < Market ceiling Market = Replacement cost
Market floor < Market ceiling < Replacement cost Market = Market ceiling
Table1. Market value is taken as inventory replacement cost, except under two conditions. Firstly, when replacement cost is above market ceiling, market value is taken as the ceiling. Secondly, when replacement cost is below the market floor, market value is taken as the floor.

How do You Value Inventories With Lower of Cost or Market Rule?

How do you set "market" value for inventory, in order to apply the Lower of cost or market rule? And, how do accountants recognize changes in inventory value under the rule? The following sections address these questions with examples.

Determining Inventory Value Under the LCM Rule

Under the LCM rule, inventory value is determined and reported each reporting period. The specific prescribed accounting methods for doing so vary slightly from country to country and accountants applying the rule should be familiar with local policies and practices.

For reporting inventory values in the United States, accountants should be familiar with US Government IRS Publication 946,"How to Depreciate Property." They should also periodically review Financial Accounting Standards Board (FASB) and APB Accounting Research Bulletin(ARBs), statements and updates. Chapter 4 of ARB 43, amendment FASB FAS 151, and subsequent amendments, are especially relevant for the LCM rule.

Example Inventory Re-Valuation

As an example, consider a business with a single inventory account to value at the end of each period. Table 2, below, shows how inventory data stand at the end for four successive fiscal year quarters.

  INVENTORY DATA
End of
First Quarter
End of
Second Quarter
End of
Third Quarter
End of Fourth Quarter
COST FOR LCM COMPARISON
 
1. The cost (Historical cost)$100,000$95,000$85,000$72,000
FACTORS DETERMINING THE MARKET
 
2. Replacement cost$107,000$95,000$90,000$75,000
3. Selling price in the market$120,000$90,000$86,000$80,000
4. Cost to sell or dispose$2,100$2,000$1,900$1,800
5. Normal profit$12,000$9,000$8,600$8,000
6. Market ceiling: Net realizable value (NRV)
           Row 3 – Row 4
$117,900$88,000$84,100$78,200
7. Market floor: NRV – Normal profit
           Row 6 – Row 5
$105,700$79,000$75,500$70,200
MARKET FOR LCM COMPARISON
8. The Market$107,000
Second Row
$88,000
Sixth
Row
$84,100
Sixth Row
$75,000
Seventh
Row
RESULT
 
9. LCM Reported inventory
$100,000
Cost
$88,000
Market
$84,500
Market
$72,000
Cost

Table2.  At the end of each reporting period (fiscal year quarters), an accountant chooses between "Market" or "Cost" as the appropriate value to report for inventory.

Data in Table 2 enable owners to apply the LCM rule and report inventory value as either Cost or Market. Note especially that inventory levels can fluctuate from quarter to quarter, Also, the factors in Rows2 through 8 of Table 2 can change from quarter to quarter.

As each quarter ends, however, accountants find inventory value to report under the LCM rule as follows.

End of Q1: Inventory Acquired, Value at Cost

At the end of Q1, the company reports replacement cost ($107,000, Row 1) as the Market value for LCM comparison (Row 8). This is because Replacement cost is between the Market ceiling ($117,900, Row 6) and the Market floor ($105,700, Row 7). That is:

  • Market Floor < Replacement Cost < Market Ceiling, therefore Market = Replacement cost.
  • Under LCM, inventory value for reporting (Row 9) is the $100,000 Cost (Row 1) because Cost is lower than Market  value ($107,000, Row 8). That is, Cost < Market.

    Therefore, report Cost.

End of Q2. Inventory Re-Values to Market

At the end of Q2, the Market value for LCM Comparison (Row 8) turns out to be the Market ceiling, or NRV ($88,000, Row 6). This is because Replacement cost ($107,000) is greater than the Market ceiling. That is:

  • Market Floor < Market Ceiling < Replacement Cost, therefore Market = Market Ceiling.
  • Under LCM, inventory value (Row 9) is the $88,000 Market value. This is because Market is less than Cost. That is, Market < Cost.

    Therefore, report Market.

End of Q3. Inventory Re-Values Again to Market

At the end of Q2, the Market value for Comparison (Row 8) is the Market ceiling, or NRV ($84,100, Row 6), because replacement cost($90,000) is greater than the Market ceiling. That is:

  • Market Floor < Market Ceiling < Replacement Cost, therefore Market = Market Ceiling.
  • Under LCM, Reported inventory value (Row 9) is taken as the $84,500 Market value because Market is less than Cost. That is, Market < Cost.

    Therefore, report Market.

End of Q4. Inventory Re-Values to Cost

At the end of Q4, the replacement cost ($75,000, Row 1) is used as the Market value for LCM Comparison (Row 8), because Replacement cost is between the Market Ceiling ($78,200, Row 6) and the Market Floor($70,200) That is:

  • Market Floor < Replacement Cost < Market Ceiling, therefore Market = Replacement cost.
  • Under LCM, Reported inventory value (Row 9) is taken as the $72,000 Cost (Row1) because Cost is lower than the Market value ($75,000, Row 8). That is, Cost < Market

    Therefore, report Cost.  

Accounting For and Reporting Inventory Changes Under LCM Rules

Inventory levels can change from reporting period to reporting period, due to product sales, inventory replenishment, spoilage, obsolescence, and other factors. With a double entry accounting system (as used by the vast majority of businesses), bookkeepers and accountants recognize a change in inventory level from such factors with at least one pair of account transactions. Note especially, these may involve accounts for inventory, cash on hand, sales revenues, accounts receivable, cost of goods sold expenses, or spoilage expense.

For purposes of clarity and simplicity, however, examples in this section omit transactions due to changes in inventory level. Instead, this section focuses only transactions that recognize inventory value changing from "Cost" to "Market" or the reverse.

Example: Re-valuing inventory

Consider again the four end-of-period inventory reports above, in Table 2. Table 3 below repeats the same period-end Cost and Market figures. Also, however, this table shows the balance to report for three accounts:

  • (1) Inventory account. This is a Balance sheet asset account that carries (like other asset accounts) a debit(DR) balance. The balance value for this account results from applying the LCM rule.
  • (2) Allowance account for LCM. This is a contra asset account—a Balance sheet account—that carries a credit (CR) balance.
  • (3) LCM Expense account. Like other expense accounts, this is an Income statement account that carries a debit (DR) balance.

Date

Cost

Market
(1)
Inventory
account
DR balance
(2)
Allowance account reducing inventory to LCM
CR balance
(3)
Expense account reducing inventory to LCM
DR balance
End FY Q1$100,000$107,000$100,000$0$0
End FY Q2$95,000$88,000$88,000$7,000
$7,000
End FY Q3$85,000$84,100$84,100$900$900
End FY Q4$72,000$75,000$72,000$0$0
Table 3. Account balances in three accounts at the end of four reporting periods, including periods in which inventory value reports change from cost to market (FY Q2) and then back to cost (FY Q4). This example does not show changes in other accounts due to inventory level changes.

End of Q1: Inventory acquired, valued at cost

From acquisition through the end of Q1, inventory value was cost. This is because cost was always lower than market.

  • The Allowance account has $0 balance because there were no LCM adjustments yet.
  • And, the Loss expense account has $0 balance for the same reason.

End of Q2. Inventory re-values to market

During Q2, Market value (from the previous section) fell below cost. The cost value, moreover, is $7,000 greater than Market value. In applying the LCM rule to report a value below cost, accountants apply two adjusting transactions to recognize the loss of value.

  • The allowance account for reducing inventory to LCM must now show a credit balance of $7,000. A credit (CR) transaction of $7,000 to this contra asset account increases the balance to that level.
  • The loss expense account for reducing inventory must now show a debit balance of $7,000. A $7,000 debit (DR) transaction to this expense account increases account balance to that level.
These transactions may appear in the journal as follows:

DateAccountDebit
Credit
31-Jun-14
31-Jun-14
  895 Loss expense reducing inventory to LCM
  125     Allowance, reducing inventory to LCM
$7,000 
$7,000

End of Q3. Inventory re-values again to market

At the end of  Q3, both inventory market value and cost were below their previous quarter levels. The inventory value to report will again be market, because market is still below cost. However the difference between market and cost is smaller than it was at the end of Q2. 

  •  Market ($84,100) is now only 900 below the Cost figure ($85,000). Therefore, the allowance account for reducing inventory to LCM must now show a credit balance of $900. A debit  (DR) transaction of $6,100 to this contra asset account decreases the account CR balance to $900.
  • The loss expense account for reducing inventory must now show a debit balance of $900. A credit (CR) transaction of $6,100 to this expense account decreases the account DR balance to that level.
These transactions may appear in the journal as follows:

  Date  Account Debit
 Credit
30-Sept-13
30-Sept-13
  124 Allowance, reducing inventory to LCM 
  895     Loss expense reducing inventory to LCM
$6,100 
$6,100

End of Q4. Inventory re-values to cost

At the end of Q4, the inventory cost is again below market, which means that the owner again reports the cost value. This requires that both adjustment accounts return to 0 balance.

  •  Because cost is again below market, the contra asset allowance account receives a $900 debit to bring its balance to $0.
  • For the same reason, the loss expense account receives a $900 credit to bring its balance to $0.
Date AccountDebit
Credit
31-Jun-2013
31-Jun-2013
  124 Allowance, reducing inventory to LCM
  895     Loss expense reducing inventory to LCM
$900 
$900

Examples in this and the previous section show valuation and reporting for a single inventory account. Note that the reporting accountant usually has freedom to choose between

  • Applying the LCM rule to the value of all inventory.
  • Or, instead, applying the rule to the values of different classes of inventory,
  • Or, even applying the rule item by item through the inventory. 

The latter is generally the most conservative of these approaches. That is, the latter approach is least likely to overstate income or asset values. 

LCM changes impact the Income statement and Balance sheet

The Balance sheet impacts occur when the contra asset allowance account has a non-zero balance. The allowance account balance reduces book value of inventory by the balance amount.

Income statement impacts occur when the loss expense account carries a non zero balance. This expense (account balance), like other Income statement expenses, is subtracted from net sales revenues to lower reported profits.   

How do You Value and Report Securities Under the LCM Rule?

Securities that companies hold as assets include both debt instruments (corporate bonds, government bonds, and treasuries, for example) and equity instruments (such as corporate stock shares). The term securities also includes derivative instruments such as options, futures, and swaps.

Just how they value and report these securities can depend on several factors. These include the purpose for acquiring them and the length of time they will beheld. Note that the valuing and reporting of securities is an area that includes controversies. And, this area has ample room for judgment and choice by accountants.

For the accounting practice in the United states, see, for example US Financial Reporting Standard 25 (FRS 25) "Accounting for Investments," from the Council on Corporate Disclosure and Governance (CCDG).  Accountants in the US should also be familiar with Financial Accounting Standards Board publication FAS 115"Accounting for Certain Investments in Debt and Equity Securities" and its subsequent amendments. This publication has been the moving force behind a strong trend in the US towards valuing marketable securities at Market ("mark to market" rule) instead of "lower of cost or market." In the US, in fact, the LCM RULE is rarely used now for securities.

Summary of Securities Valuing Methods

With these cautions in mind, the following summary simply presents a sample of valuing methods that may apply in a different situations.

•  Class of securities assets holdings.
•  Investments in securities vs. marketable securities.
     –  Minority, passive investment.
     –  Minority, active investment.
     –  Majority, active investment.
• Classes of marketable securities.

Which Securities Assets Are Eligible For LCM Treatment?

Table 4 below shows the LCM rule in context with other securities valuing methods. As a result, this article describes valuing methods for a wide range of securities holdings.

  SECURITIES ASSETSKind of securitiesInitial value at...Subsequent valuation at
Investments in Securities 
Minority, passive investmentEquityCostMarket or Lower of cost or market
Minority, active investmentEquityCostEquity method
Majority, active investmentEquityCostEquity method
MARKETABLE SECURITIES 
Trading securitiesEquity or debtCostMarket or Lower of cost or Market
Available for tradingEquity or debtCostMarket or Lower of cost or market
Debt held to maturityDebtCost 
Derivative instruments 
Derivatives with available
market
DerivativeCost 
 Derivatives, negotiated
 purchase
DerivativeCost 
Table 4. Representative valuing methods for different classes of securities assets. In some areas there is either controversy regarding the appropriate valuing method, or some room for flexibility and choice on the part of the reporting company.  

Investment vs. Marketable Securities
What Are the Differences?

For accounting purposes, the majority of debt and equity securities assets are classified either as investments in securities or marketable securities. Securities assets are considered marketable securities if two conditions apply:

  1. There is an active, accessible market for the securities. This means these securities can be considered liquid assets with a market value that is reliably assessed. 
  2. The company may sell the securities when it needs the cash or there is a financial advantage for doing so.

If either condition does not apply, it is assumed that the securities were acquired for long term objectives and they are reported as long term assets. Equity securities held for long term objectives which do not meet both of the above criteria are called Investment in Securities assets, not marketable securities.

Investments in Securities: Minority Passive Investments

When Company A owns less than 50% of the voting stock in Company B, and when Company A does not attempt or intend to attempt to use its minority ownership to influence or control actions or decisions company B, A may be said to have a minority passive investment interest in B. In fact, However, the "minority passive" designation is usually applied only when one company owns 20% or less of another company's stock: there is a presumption that 20% ownership or greater implies an "active" interest.

The minority passive owner initially records the investment at acquisition cost. In many countries other than the United States, minority passive securities holdings are valued and reported under the lower of cost or marketing rule. For the US, however, the rule may or may not be applicable, depending on local policies and practices. In some US locales, subsequent values will be reported at Market value, regardless of whether Market is above or below cost. In any case, for reporting minority passive investment securities in subsequent periods the following apply:

  • Any dividends received from the minority passive investment are recorded and reported as revenues.
  • The securities assets are reported (a) Market, or (b) Lower of cost or market. Adjustments to a new value from the previous period end value can be accounted for with two equal, offsetting adjustment transactions such as those illustrated above for inventory valuing.

    A debit to a "Loss expense" account will impact reported profits on the Income statement.

    A credit to a contra asset "allowance account" will impact book value of the asset.

  • If the assets have been sold during the accounting period, the adjustment accounts are brought zero and a gain or loss is measured with respect to acquisition costs, bringing the appropriate tax consequences.

Investments in Securities: Minority Active Investments

The classification minority active investments usually applies to companies owning between 20% and 50% of the voting stock in another company, which do attempt to use this ownership to influence or control that company. In such cases, Company A is said to have a minority active investment interest in B.

Even though Company A does not have majority ownership of B, Company A can still attempt to exert influence by acting in concert with other minority owners to form a majority voting block (for example, enlisting other shareholders in a proxy fight). Or, minority owners may exert influence simply by threatening to acquire enough additional stock to give them majority ownership (i.e., threaten takeover).

When Company A takes an Active investments interest in influencing or controlling Company B, even though it has a minority ownership, A must use the equity method of accounting for valuing and reporting is securities assets (Company B stock shares). As with the passive investment situation, active owners first record minority ownership stock at cost.

Equity Securities Held as Minority Active Investments

Equity securities held as minority active investment are initially valued at Cost. At the end of reporting periods, however, Owners apply the equity valuation method to value them.

  • Each period, the investing firm recognized revenue equal to its proportionate share of the firm. The investing company's (Company A's) proportional share of the associate company's net income increases the investment and a net loss decreases the investment.
  • On Company A's Income statement, the proportional share of Company B's net income or net loss is reported as a single line item.
  • When company B pays dividends, A's proportional share of dividends are not considered revenue, but rather as return of capital. A's investment decreases by the amount of dividend payment.
  • Dividends reduce the asset and are not revenue but rather a return on capital.

Investments in Securities:  Majority Active Investments

When company A owns more than 50% of Company B, A is in a position to exercise absolute control over B. In such cases, A is said to be the parent company, and B is its subsidiary. In such cases.

Because one economic entity can control several legal entities and because there is a risk that income might be manipulated by economic transactions between the legal entities. To ensure that such transactions are transparent, U.S. GAAP requires the following: Financial statements of the legally separate entities must be combined and reported as parts of a Consolidated Financial Statement for the controlling economic entity.

Consequently, Company A and Company B can be separate legal entities, but for Financial Accounting purposes (at least in the US), they must report together through one consolidated financial statements.

What Are The Major Classes of Marketable Securities?

Securities holdings qualify as marketable securities if they meet two criteria.

  • Firstly, there must be an accessible, active market for these securities.
  • Secondly, the company intends to sell these holdings when it is advantageous to do so.

When the owner first acquires marketable securities, their Balance sheet value is set to acquisition cost. (Most asset categories, in fact, use acquisition cost for initial value). Acquisition cost for securities includes purchase price, of course, but also other purchase-related costs, such as brokerage commissions.

For late reporting periods, however, the owner reports a value for marketable securities that may be subject to the lower of cost or market rule. Or, they may instead be subject to the "mark to market" rule, depending on local policies and practice.

Marketable securities are classified as:

  • Trading securities.
    Securities presumably held for relatively short term gains. Owners normally trade securities in this class actively.
  • Securities available for sale.
    These are securities which the owner may or may not hold for long term gains. It is usual to hold marketable securities in this class for a while, to meet a specific cash need(e.g., to retire company-issued bonds that will be coming due).
  • Debt held to maturity.
    These are debt securities, such as bonds, which the owner intends to hold to maturity.
  • Derivative Instruments.
    These are options, swaps, or futures, which the owner holds either as insurance or expecting they will turn into profit making investments in their own right.

    If there is an open, accessible market for the derivatives, they may qualify as marketable securities

    If instead the owner acquires derivatives through private contract negotiations, they do not qualify as marketable securities.

Marketable Securities: Valuing Trading Securities

Trading securities may be either equity securities or debt securities. Presumably these are held for short-term gains. As a result, owners use trading security portfolios for active buying and selling, hoping to earn profits. Because they are typically held for the short term, trading securities are carried on the Balance sheet as Current assets. The vast majority of trading securities belong to financial institutions.

Owners first record trading securities in a Balance sheet assets account with value equal to cost. For example, consider a $100,000 equity securities cash purchase. If the owner intents to hold these securities as trading securities, the purchase transactions are as follows. Note that the acquisition occurs in the middle of a reporting period, Q4 FY2012.

  • A $100,000 debit (addition) to a current assets account, Marketable securities.
  • A $100,000 credit (decrease) to a current assets account, Cash on hand.
Date Account   Debit
Credit
15-Nov-13
15-Nov-13
 895  Marketable securities                   
  125     Cash on hand                              
   $100,000 
$100,000

Trading Securities After Market Value Changes

If, for example, market value increases by $5,000 by end of the quarterly period, and if the accounting policy is mark to market, accountants recognize the change in value with two account entries. At the end of, Q4:

  • A $5,000 debit (addition) to a Balance sheet current assets account for Marketable securities.
  • A $5,000 credit (increase) to the Income statement revenue account for unrealized holding gain.
DateAccountDebit
Credit
31-Dec-13
31-Dec-13
  895  Marketable securities
  125     Unrealized holding gain
$5,000
$5,000

If instead the market value of these securities decreases, the adjusting transactions include a credit (decrease) to Marketable securities and a debit (decrease) to Unrealized holding gain.

Trading Securities Impact On the Income Statement

Net gains and losses for trading securities impact Income statement earnings for the period they are reported, even if the gains or losses are not yet realized in that period. This is because there is a presumption realization will in fact occur in the short term.  

If the owner sells these securities during Q1 for $120,000, that brings a net gain of $20,000 over their original cost of $100,000. Of this gain, however, $5,000 have already been closed to income as unrealized gains (above). Now, three more transactions recognize the sale:

  • A $120,000 debit (increase) to a cash account, recognizing receipt of funds for the sale.
  • A $105,000 credit (decrease) to marketable securities. This was the last value for the securities the owner is no longer holding. 
  • A  $15,000 credit (increase) to a Realized gain account.
Date AccountDebit
Credit
31-Mar-14
31-Mar-14
31-Mar-14
  101  Cash on hand
  125     Marketable securities
  333     Realized gain on securities
$120,000 
$105,000
$15,000

The company realizes a gain of $15,000, which appears as income on the Income statement.

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